This Is Your Brain on Money by Laura Rowley

One afternoon on his way to lunch, New Yorker Jason Zweig found a roll of bills on the sidewalk that totaled $300.

He subsequently picked up the restaurant check for his office mates, took his girlfriend out to dinner, and splurged on some books, music, and a few classy ties. When all was said and done, he'd blown $430 -- or $130 more than his lucky strike.

Eager Spenders

Researchers have found that an unexpected windfall makes people more eager to spend than an expected one, as Zweig discovered in writing his new book, "Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich."

In the book, Zweig, a senior writer at Money magazine and editor of the revised edition of Benjamin Graham's classic "The Intelligent Investor," examines the psychological, neurological, and biological phenomena that drive foolish financial behavior.

"It's very important for people to realize that this is not a study by very smart people of how stupid the rest of us are," says Zweig. "If you talk to the researchers, they make the exact same mistakes that they spend their careers documenting."

Here are five ways your brain can trick you into making financial blunders, and how to avoid them:

1. Familiarity breeds admiration, not contempt.

Psychological research shows that we're attracted to the familiar, Zweig says. A simple test proves his point: Take a digital photo of yourself, and using photography-manipulation software, flip it to the reverse image so that if it was shot from the left, it now looks as if it was taken from the right.

"You'll have a strong preference for one of those images and not the other -- because one is your mirror image, the other is the image that people see when they look at you," says Zweig. "Whenever a stock, an industry, a market, a country, or an investing theme is familiar, you'll like it better. But familiarity is very dangerous."

One example: More than 5 million Americans have at least 60 percent of their 401(k) savings in the stock of the company where they work. Investment advisors recommend holding no more than 5 percent.

On the other hand, what about the famous advice of legendary Fidelity fund manager Peter Lynch, to invest in what you know? "That's not what Peter Lynch said," Zweig says. "He did invest in Chrysler after getting a minivan, but he didn't invest only because he liked the minivan -- he researched the stock. If he hadn't liked what he saw when he researched the company, he wouldn't have bought the stock."

Whenever you feel an investment is a no-brainer, stop and write down 8 to 10 different reasons why you must be right, Zweig advises. If you find after three or four that you can't think of any more, think twice before buying.

2. The pattern you swear you see is probably an illusion.

The brain is built to detect patterns, even when confronted with an arbitrary occurrence. "A small streak of random luck looks to us like part of a longer pattern of reliable foresight," Zweig writes.

After someone learns a set of circumstances through which they made money, the brain will fire up with the pleasure chemical dopamine when those conditions occur again. "If you see something once, then twice, you automatically, involuntarily expect it a third time," Zweig says.

"You associate a signal with a result -- 'when I listen to that guy on CNBC and I do what he tells me, I make money.' If that happens to you twice, and if you see him again on TV, dopamine is released, and you'll buy what he recommends because just seeing him will give you a good feeling. The intensity of expectation really gets you into trouble."

Investors relying on technical analysis tend to succumb to this problem. "As soon as a stock seems to conform to a pattern that has made money before, an 'I-got-it' effect kicks in, making investors feel sure they know what's coming next -- regardless of whether there's any objective reason to believe they do," Zweig explains. Even sophisticated investors tend to hire money managers who are on a three-year hot streak.

Zweig says one way to prevent your brain from reacting to these "three-peats" is to use dollar-cost averaging -- investing the same amount every month in a fund or stock that's part of as larger long-term strategy based on your goals.

3. Everything is relative.

The brain will hook onto a number and then compare subsequent figures to the initial one, a phenomenon known as "anchoring and adjustment." It's why real estate agents tend to show a potential buyer the most expensive house first, because subsequent ones will seem inexpensive; and why mutual fund companies nearly always launch new funds at a "cheap" price of $10 a share.

The solution? Avoid the numbers. Zweig quotes Warren Buffett, who says he always likes to look at investments without knowing the price, "because if you see the price, it automatically has some influence on you."

4. Tune out the play-by-play.

If you're someone who obsessively monitors the prices of your holdings, watch out. Several studies by Princeton Nobel laureate Daniel Kahneman and other researchers have found that the more often people watch an investment move up and down, the more likely they are to trade in and out short-term -- and the less likely they are to earn a high return over the long term.

"If owning stocks is a long-term project for you," Kahneman tells Zweig, "following their changes constantly is a very, very bad idea. It's the worst possible thing you can do, because people are so sensitive to short-term losses. If you count your money every day, you'll be miserable."

5. Beware of group-think.

"When the market gets really greedy or really fearful, basically everyone's brain starts to work the same way," says Zweig. "That's why many people buy high and sell low."

A New York University researcher performed MRI scans on subjects as they watched the Clint Eastwood film "The Good, the Bad and the Ugly." "Throughout most of the movie, the brain scans were all over the map," says Zweig. "Then there's a scene in which Clint Eastwood blows the bad guy's head off. Everyone had the same reaction -- fear and alarm. The lesson is that, at emotional turning points, people think alike."

To avoid following the herd, set your own financial policies and rules, and stick by them.

"Try to determine what your long-term goals are, put a really good financial plan in place, and follow it," says Zweig. "The worst imaginable thing you can do is listen to Pied Pipers who tell you 'here are seven tricks to beat the pros at the game.' That game will make you miserable."